Thursday, August 25, 2016

Regulation Crowdfunding: Are You the Right Candidate for It?

As you all probably already know, in 2015 the Securities and Exchange Commission (or the SEC) adopted Regulation Crowdfunding to implement Title III of the Jumpstart Our Business Startups (JOBS) Act.  The Regulation Crowdfunding (or Regulation CF) became effective on May 16, 2016.  So, let's summarize the regulation and see how the Regulation Crowdfunding has been doing in its first three months of existence.

Offering Amount

Here is one of the most important (and limiting) limitations of offerings pursuant to Regulation CF: a company can raise only a maximum of $1 million in a 12-month period.  The good news is that this does not affect the amounts that the company can raise in other exempt (non-crowdfunding) offerings during that same 12-month period.  So, conducting a Rule 506(b) private placement to accredited investors and a Regulation CF offering at the same time is possible.

The Investors

The good news is that investors do not have to be accredited.  However, there are limits as to how much individual investors can invest.  They are:

  • if annual income or net worth is less than $100,000 - then $2,000 or 5% of the lesser of the investor's annual income or net worth; and  
  • if both annual income and net worth equals to or more than $100,000 - then 10% of the lesser of annual income or net worth.
In any 12-month period, an individual investor cannot invest more than $100,000 regardless of such person's annual income or net worth.  Spouses can calculate their net worth and annual income jointly.

The Portals

Each Regulation CF offering must be conducted exclusively through one of the funding portals registered with the SEC and FINRA.

The Issuers


First, let's talk about the issuers (i.e., the startup companies that can use this rule to raise money from the general public).  What type of companies can participate?  The Regulation tells us that certain companies cannot:
  • non-U.S. companies;
  • companies that are already public reporting companies;
  • certain investment companies;
  • companies that have been disqualified under the disqualification rules (see my earlier posts here and here)
  • companies that have already conducted an offering pursuant to Regulation CF and then failed to comply with the annual reporting requirements; and
  • companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company.

The issuers have to prepare and file an offering statement on Form C through the SEC's EDGAR system.  What information should be included in this offering statement?  Here is a list:
  • information about officers, directors, and owners of 20% or more;
  • a description of the company's business;
  • the use of proceeds of the offering;
  • the price to the public (or how the price is determined);
  • the target offering amount and the deadline to reach it;
  • whether the company will accept investments in excess of the target offering amount;
  • certain related-party transactions; and 
  • a discussion of the company's financial condition and financial statements.
The financial statements requirements depend on the amount offered and sold in reliance on Regulation CF in the preceding 12 months:
  • if no more than $100,000: financial statements of the issuer and certain information from the issuer's federal tax returns, both certified by the principal executive officer (unless CPA-audited or reviewed statements are available);
  • if more than $100,000 but no more than $500,000: financial statements reviewed by an independent public accountant (unless audited statements are available);
  • if more than $500,000: financial statements reviewed by an independent public accountant.
While the offering is ongoing, the issuer will need to amend Form C to disclose any material changes or updates (and then re-confirm all commitments).

The issuer may also need to file Form C-U to update on the progress towards meeting the target offering amount, unless the portal provides frequent updates.

Then comes an obligation to provide annual reports on Form C-AR on a yearly basis and post those on the website until one of the following takes place:
  • the issuer becomes a public company;
  • the issuer has filed at least one annual report and has fewer than 300 holders of record;
  • the issuer has filed at least three reports and has less than $10 million in total assets;
  • the issuer or another party purchases or repurchases all of the securities issued pursuant to the Regulation CF, or
  • the issuer liquidates or dissolves in accordance with state law.
These are onerous requirements that can become quite costly in terms of legal fees.  Fortunately, some portals assist companies with preparation of Forms C. There is also iDisclose, an exciting young company founded by lawyers, that can expertly generate for you a Form C (or a PPM, if needed). iDisclose actually works with SeedInvest, Republic, and several other portals on preparing Forms C for their crowdfunding clients.

Advertising, Communication, and Promoters

The company engaged in Regulation CF crowdfunding may not advertise, but it is allowed to provide factual information.  It can only post a notice directing prospective investors to the portal's platform.  The notice can include the following:
  • a statement that the issuer is conducting a Regulation CF offering;
  • the name of the portal it is using and a link to it;
  • the terms of the offering (amount, terms of the securities, price, closing date); and
  • information about the legal entity and business location of the issuer and a brief description of the business.
The issuer can communicate with investors and prospective investors through communication channels provided by the portal.  Of course, it doesn't mean that the company cannot talk to anyone at all outside of the portal.  The company representatives can still attend conferences and talk to prospective investors.  But they need to limit the information they give to the four points listed above, and avoid statements such as "my ... doughnuts ... are the best doughnuts in the world."

The issuer may compensate others to promote its offering through the portal, but needs to make sure that the promoter clearly discloses the compensation with each communication.

Need a Transfer Agent

When conducting a Regulation CF offering, companies should engage a transfer agent.  Here is why.  There is Section 12(g) of the Exchange Act that says that every issuer with total assets of more than $10 million and over 2,000 record holders of its securities (or 500 not accredited) must register that class of securities with the SEC.  There is an exemption.  Securities issued pursuant to Regulation CF are exempt from the holder count so long as the following criteria are met:
  • the issuer files its annual reports on Form C-AR on time;
  • it has less $25 million or less in total assets; and 
  • ***it has engaged the services of a transfer agent registered with the SEC.
Current Practice

According to Stratifund, in just one week after the Title III crowdfunding became available on May 16, 2016:
  • $21 million: Amount startups are seeking to raise
  • $1 million: Amount invested in startups in week 1
  • 32: Startups launched their campaigns.
As of August 24, 2016, 88 Form Cs (offering statements) have been filed with the SEC which means that 88 Regulation CF campaigns have been launched. Some of the Regulation CF funding portals are NextSeed, Wefunder, SeedInvest, FlashFunders, StartEngine, TruCrowd, and Republic.

The securities offered are all over the spectrum: debt, revenue sharing, SAFE, preferred stock, LLC units, convertible debt, and common stock.  Some portals have been developing new forms of securities that are specifically geared towards Regulation CF offerings (in an attempt to address the main problem: managing a large number of small shareholders).

Let's take a look at NextSeed, a crowdfunding portal in Texas.  It actually has two portals: one for Regulation CF projects, and another one registered with the Texas State Securities Boards that conducts intra state offerings.  Revenue sharing seems to be the preferred method of crowdfunding financing at NextSeed.  According to their disclaimer, NextSeed assists small businesses issue debt securities in the form of term notes, revenue sharing notes, and other debt products.

Here is one of the funded campaigns that closed on August 23, 2016: the Brewer's Table.  The minimum investment is $100, and there is no limit for accredited investors.  There are 190 investors and the company raised $300,000. The company is a Texas LLC, and is offering revenue sharing notes.  Investors will not receive equity in the company.  Following a startup up period of 5 months, investors will start receiving 5.25% of each month's gross revenue, distributed pro rata among them, up until each investor receives 1.5x their original investment.  If the investors have not been paid in full in 40 months, the company is required to promptly pay the entire outstanding balance.  The note is secured with the company's assets.

Let's now turn to WeFunder.  This portal suggests that Wefunder companies consider offering one of four types of securities specifically developed by them for Regulation CF offerings: WeFunder SAFEs, promissory notes (with or without discount or valuation cap), revenue loan agreement, and investor perks agreements (that can be combined with one of the other three types of offerings). All documents are available on their website free of charge.  For Regulation CF offerings, Wefunder charges investors up to 2% of their investment and the company up to 3% of their total funding volume.

Here is Hawaii Cider Company that is currently doing a raise on WeFunder.  The company is offering a SAFE with a $7 million valuation cap and a 10% discount with some additional interesting features. The company is also offering various investor perks based on investment amount.

On SeedInvest's website,  you can find ongoing offerings in three categories: Regulation CF offerings made through their SI Portal, Regulation A offerings, and offerings open to accredited investors only (need to log in first).  SI Portal receives cash compensation equal to 5% of the value of the securities sold and equity compensation equal to 5% of the number of securities sold.  At this time, there are only two companies raising money through SI Portal, both offering preferred stock.  


There can be no conclusion to this blog post.  The field of Regulation CF is rapidly developing, changing, adapting, and growing.  It is exciting to see some small businesses getting funded, and small investors finally being able to participate in the start-up community.  Let's keep on watching, learning, and investing!

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.

Tuesday, March 8, 2016

Electronic Signatures: OK to Use?

This blog post focuses on the use and validity of electronic signatures. We will first investigate what constitutes an "electronic signature", we will then discuss the validity and enforceability of electronic signatures, and finally, we will talk about the risk involved with unauthorized use of electronic signatures and how to minimize it.

What are "electronic signatures"?

The federal law titled the Electronic Signatures in Global and National Commerce Act (also called ESIGN Act) defines an electronic signature as “an electronic sound, symbol, or process attached to or logically associated with an electronic record and executed or adopted by a person with intent to sign the record.” This broad definition allows flexibility in what may be considered an electronic signature and permits individuals and businesses to use different types of technologies and methods to create valid and legal electronic signatures. Examples of electronic signatures include:
  • Keyboard characters entered in a specific order, such as a PIN number or a password;
  • Clicking a button or checking a box to agree to the terms shown on a screen, called a “click wrap” system;
  • Signing an electronic keypad; 
  • A graphical representation, image or a scan of a handwritten signature; or
  • Agreeing to terms described in an email that would suggest acceptance of terms in the email.
Another type of electronic signature is a digital signature, which uses technology called a Public Key Infrastructure (PKI) to make a unique pattern that is coded into an electronic document. This acts as an identifier that is unique to the signer to guarantee identity, intent, and integrity of the document for verification purposes. Because of this technology, the digital signature is more secure than the traditional types of electronic signatures.

In the current environment where many communicate through email, the laws of electronic signatures also apply to email. A person can make enforceable agreements through email if the email contains the important and material terms of the agreement and clearly shows that both parties intended to agree to the terms set forth in the email. In this case, the electronic signature can come in the form of the signer’s name at the end of the email, though courts have found that automatic signature blocks at the end of an email are not sufficient for an electronic signature. In order to have a valid electronic signature in an email, the signature should show that the person manually entered the name with the intent to agree and sign. Suggested signatures in an email include:
  • Preceding or including a unique character in addition to the signer’s name, such as “/s/”;
  • Using a unique method of entering the signer’s name, such a cursive font or script; or
  • Using a graphical representation or image of the signer’s name.
Are “electronic signatures” valid?

The ESIGN Act protects the validity and enforceability of signatures made electronically. According to the ESIGN Act:
  1. a signature, contract, or other record relating to such transaction may not be denied legal effect, validity, or enforceability solely because it is in electronic form; and 
  2. a contract relating to such transaction may not be denied legal effect, validity, or enforceability solely because an electronic signature or electronic record was used in its formation. 
The ESIGN Act does not apply to certain transactions, which include:
  • Wills, trusts, and codicils;
  • Family matters, such as adoption and divorce; 
  • Most of the transactions covered by the Uniform Commercial Code; however, other statutes that relate to transactions under the Uniform Commercial Code allow electronic signatures for transactions that are exempt from the ESIGN Act; 
  • Notices of default, foreclosure or eviction; 
  • Termination of utility services; 
  • Termination of health or life insurance; 
  • Product recalls; and 
  • Documents related to the transportation of hazardous materials. 
The ESIGN Act does not require a person to use or accept electronic signatures if the parties prefer traditional methods of signatures. This means that there must be consent from the parties to enter into the transaction through electronic means. Consent can be explicit (such as a clear indication in writing that the parties intend to enter into the transaction through electronic methods) or implicit (such as a signer frequently accessing a website or repeatedly communicating through email and the terms of the agreement are set forth in the email – a one-time email may not be sufficient).

Unauthorized use of electronic signatures

Now, let’s discuss the legal consequences of somebody else using a person's electronic signature without authorization.  There is a risk that such person will be held liable even if hedid not authorize the use of the image containing his electronic signature.  However, there are ways to minimize this risk.  Remember that the ESIGN Act requires the signer to have “intent to sign the record.”  So, whoever signs electronically, should be able to confirm his identity and the “intent to sign.”  If a person's electronic signature was used without authorization, then such person should be able to prove the opposite: that it was not him who signed and that he did not have any intent to sign that particular document.  How to prove that?  Below are several suggestions:
  • Set up procedures to protect and limit access to your e-signature (PINs, passwords, restricted access);
  • Consider using a digital signature with PKI technology;
  • If an email is used, then always keep email trail that shows who had access to your e-signature; and
  • Keep records of computer systems that link computers and IP addresses to show who may have accessed the image or sent the agreement with the image.
Since the ESIGN Act requires “intent to sign the record,” any evidence that shows lack of intent helps the signer avoid liability in the event of unauthorized use of the image.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.

Wednesday, February 24, 2016

Winter 2016: raising funds may become more difficult for some startups

I attended several VC events in New York City recently, including Ask a VC forum on February 4, organized by DLA Piper, and the VC Summit on January 26, organized by Gotham Media.  I learned some interesting insights, which may be useful for those startup founders looking to raise capital now.

Current investment climate.  Everybody noted that the current investment climate has changed. VCs who participated in the panel discussions all agreed that the valuations have come down (some said "a bit" and others said "aggressively"), and that it now takes longer for companies to raise their first round of capital. Recent posts by Brad Feld and Mark Suster confirm that. As Mark said: "The startup industry may be “resetting,” which doesn’t mean a “crash” but rather just a resetting of valuations, timescales, winners/losers, capital sources and the relative emphasis of growth rates vs. burn rates." So, startups should perhaps re-think their valuations and allocate extra 1-2 months to raise the needed capital, stretching the capital raising efforts from 4 to about 6 months. Having said that, great startups will still get funded pretty quickly regardless of the current downturn.

How to find VCs that will fund you.  This has been talked about so much, that it is really no longer a mystery.  VCs will rarely fund companies that have emailed them at random.  VCs tend to consider only those companies that have been pre-filtered by a trusted referral source (other VCs, advisors, their portfolio companies, etc.).  VCs like to fund repeat entrepreneurs who have already successfully existed from at least one startup.  If you are not that, then you need to do your homework.  Select VCs that are likely to invest in your company (VCs that focus on your industry and  invest in seed rounds).  Read all you can about them.  Figure out which companies they've funded in the past.  Reach out to the portfolio companies founders, and see if you can get them to like you and your startup.  Then, they may introduce you to their VCs.  Also, do not despair if these introductions do not produce immediate funding results: establish connections with the VCs and keep in touch through regular updates. Funding from them may come at a later stage.

Angel investors vs VCs.  An interesting phenomenon has developed: the appearance of micro VCs (i.e., smaller venture capital firms that are focused on early stage financing).  In my experience, an average startup would first get funded up to $1 million by angel investors (wealthy, accredited individuals).  These may be family members and friends, or other accredited investors.  Angel investors don't typically get a seat on the board, or help out with industry expertise or connections (but I've seen exceptions).  Later stages of financing are typically handled by VCs.  Now, I see more VCs come in at the seed rounds, including convertible debt financings.  It is an overall positive development for the companies because VCs tend to invest in subsequent rounds as well, and have industry expertise and connections that may prove useful to the companies. Finally, VCs bring with them expertise in running a startup.  Of course, there are disadvantages as well (since VCs want board seats, there is always a danger that once they have control of the board, they may oust the founders).

How much money to raise in the seed round?  The rule of thumb seems to be: raise enough cash to last 18 months and give up 15-20% of your company in exchange.  Just remember to start your next fundraising campaign 4-6 months before you run out of money.

What are VCs looking for?  They are looking for a scalable business model.  VCs don't want beautiful power point slides or well-scripted presentations.  They want to see substance, such as a well-stated problem, the proposed solution, clear execution plan and milestones.  Also, be prepared to explain why you need this much money and how you plan to spend it.  During the presentation, the founders should be able to explain the whole business in 20 slides or less.

Finders.  Be careful about signing any agreements with finders (people who offer to make introductions to potential funding sources in exchange for a referral fee).  First, if they are not registered with the SEC, they may get themselves and your company into trouble.  I wrote about it here.  Second, VCs don't like to see their money going to pay somebody's referral fees.

In conclusion, please remember that only a small fraction of all startups gets funded by VCs at any stage of their development, and you need to prepare well for the fundraising campaign.  As for those who are not successful with the VCs: Regulation Crowdfunding, which becomes effective on May 16, 2016, will soon open more funding sources for startup companies.  More on this topic later.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.